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Tax Planning for Sole Proprietorships With Tax Planning Software

The first article in our Deep Dive into Entity Selection series focuses on sole proprietorships.

A sole proprietorship is an unincorporated business run by a single individual where both state law and the IRS view a proprietor and their business as one entity. This means that the individual can claim the business’s revenues but is also liable for its tax, legal, and financial obligations.

A sole proprietorship is the simplest structure a business can take, and most tax experts agree that sole proprietorships have the simplest taxes. But being a good mentor for your clients extends well beyond preparing a tax form. While Schedule Cs are simple two-page forms, getting the information on those forms may take a bit of strategizing. You can sell your tax planning services to new, established, and even accidental sole proprietors by investing in a tax planning software that examines all these available strategies. This will help you select the approach that best fits your client’s needs and goals.

To help you show up for your client as best you can, let’s review sole proprietorships from the ground up.

Formation

To establish a sole proprietorship, an individual must simply begin operating their business. They can operate under their own name or they can select a fictitious name for their business, but regardless how they are named, they need not take any legal action to form an entity. While your clients may need to apply for licenses or permits, there is no requirement to register a sole proprietorship with the state as a separate entity.

Some of your clients may even have a sole proprietorship without realizing it. In recent years, the unemployed and underemployed have increasingly looked to the gig economy for work. Freelancers, temporary workers, contractors, and gig workers may choose to operate under an LLC, but most simply begin doing the work and think about their taxes later. For example, if your underemployed client chose to supplement their income by providing some sort of service – consulting others in their field, submitting expert content to publications, or creating an online course – their side business could qualify as a sole proprietorship.

Liability

Sole proprietorships are simple to form, but this simplicity comes at a cost: sole proprietors have unlimited personal liability for their business. Because there is no legal distinction between the proprietor and the business, creditors can seek debt collection from both the business’s assets and the owner’s personal assets.

If your client hires employees into their business, they may also be subject to vicarious liability. This means that the proprietor may be personally liable for the actions of their employees. If the employee was acting within the scope of their employment and they cause harm, damage, or break the law in some way, the owner may need to pay those fines from their own pocket. Business insurance can help alleviate some of this liability, but once insurance proceeds are tapped, the law permits the creditors or plaintiffs to go after the business owners themselves.

Taxes

Most sole proprietors report their earnings on a Schedule C. While earnings from some side hustles can be reported directly on Line 8 of the tax return as Other Income, you will likely save your client money if you report their business activity on Schedule C. Doing so will allow your client to deduct legitimate business expenses like office supplies, equipment purchases, and travel costs from their earnings. A tax planning software like the one we offer at Corvee can show just how much of an impact these deductions can make on your client’s overall tax liability.

In addition to income tax, sole proprietors should be concerned with self-employment tax. Self-employment tax is an additional 15.3% tax on the earnings of a self-employed individual: 12.4% for Social Security and 2.9% for Medicare. Though half of this tax is deductible, the additional tax will surprise some business owners come tax time.

As sole proprietors, your clients are required to pay their Federal and state income tax liabilities in four quarterly installments throughout the year. Federal estimated tax payments are due April 15th, June 15th, September 15th, and January 15th of the following year. A good tax software will estimate your client’s tax liability and help you prepare those payment vouchers. Those who pay their estimates late or do not make the appropriate payment will be subject to underpayment penalties and interest.

If your client has employees, they will also need to think about payroll taxes. They may need to file some (or all) of the following payroll tax forms:

If your clients have employees, you should discuss forming an LLC for their business. Doing so would limit your client’s legal liability, and unless they make an election to be taxed as a corporation, they can keep their taxes simple by continuing to report their business activities on Schedule C.

Advantages

Sole proprietorships have many advantages over other business forms.

They are easy to form.

Your client need not do anything to establish a sole proprietorship other than commence operations. This will save them money on administrative charges and legal fees.

Their taxes are simple.

Schedule Cs are generally simpler to prepare than Forms 1120 (C corporations), 1120-S (S corporations), or 1065 (partnerships).

The owner has full control over the business.

Having unrestricted operating freedom may be desirable for your client.

They allow for straightforward banking.

Because the business is disregarded for legal and tax purposes, the business owner will not be punished for commingling business and personal funds. A separate bank account may still be advisable, but there will be less focus on your client’s banking practices should they be audited.

They are often a good starting point for a small business.

Sole proprietorships are a good starting point for individuals who want to get a business up and running quickly and effortlessly.

Disadvantages

Sole proprietorships also have a few disadvantages compared to other business entities.

It can be difficult to raise money.

As a single owner, sole proprietors must contribute funds to get the business operational, or they must personally underwrite a small business loan. They cannot accept equity investment from others.

The owner is subject to unlimited liability.

A lawsuit can bankrupt both the business and the proprietor.

The business owner is the only responsible party.

Many individuals find it stressful to be the only person responsible for the success or failure of a business.

Health insurance can be costly.

Sole proprietors will likely have higher insurance costs than larger businesses because they lack purchasing power in the healthcare marketplace.

There is no business continuity.

The business itself retains no value. When the owner passes away, the business is dissolved.

Next steps

Many individuals operate sole proprietorships in perpetuity and have no desire to establish a separate business entity. But if your client is concerned about liability, they may want to establish an LLC. Transitioning from a sole proprietorship into a single-member LLC will protect your client’s personal assets, but they can continue to report their business activities on Schedule C (unless they make an election otherwise).

Entity selection is never a straightforward process, and even taxpayers who have had successful businesses for years may be operating under an entity type that isn’t serving them. That’s why a tax planning software like ours at Corvee is so helpful. Our software will state plainly what your client’s tax liability would be if they changed tax entities. These reports can be a great way to sell your tax planning services to new clients, and you may be able to encourage your existing clients to sign on for new tax consulting services. Request a demo of our tax planning software today and see for yourself how it can help.

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